Arguments for and Against the Dodd-Frank Act

Arguments for and Against the Dodd-Frank Act

Introduction

The financial system is among the most heavily regulated sectors of the economy. It is essential to have financial regulation since such rules are fundamental in avoiding financial crises, systematically resolving financial crises, preventing contagion, promoting long-term growth, limiting volatility in addition to economizing on the taxpayers’ money (Madura, 2015). Then aftermath of 2007-2008 saw the introduction of the Dodd-Frant Act, which was a direct response to the problems experienced during the global financial crises. The Act that was enacted in 2010 mandates bank holding firms with more than USD 50 billion in assets to adhere to stringent capital and liquidity standards as well as setting new limitations on managerial incentive compensation. Nevertheless, despite the firm tenets of the Dodd-Frank Act to stabilize the United States’ financial system, some Republican members in Congress emerged to roll back the Act. This paper delves into examining the need for/arguments for the implementation of the Dodd-Frank Act, including the positive effects the Act brings; and the adverse impact of the financial reform/arguments against its application.

Influence and Background of the Dodd-Frank Act

The global financial crisis of 2008 destroyed middle-class wealth and jobs. The crisis resulted from the concentration of consumer abuses and the unimpeded financial sector risks, which led to the worst economic downturn in history since the Great Recession. Gelzinis et al. (2017) state that, as a result of the crises, millions of people lost their homes while employees lost their jobs and households lost their wealth. Subsequently, the Dodd-Frank Act was enacted in 2010 to resolve these issues and prevent a further crisis from occurring. The primary objective of the Act was to develop a more stable and safer market place for consumers of financial as well as bolstering the financial stability of the United States economy (Gelzinis et al., 2017).  significantly, the passing of the Act has incredibly reformed the financial sector, and even though the economy still experiences the effects of the Great Depression, it is still recovering from the financial crisis experienced a decade ago, with a more stable financial industry.

Considering the problems experienced during the financial crisis, it was evident that the restriction available during the time did not adequately protect financial consumers from the risks of toxic financial products. The Dodd-Frank Act aimed at fixing this issue by establishing the Consumer Financial Protection Bureau- an agency that was tailored towards protecting consumers within the financial market (Gelzinis et al., 2017). Since its introduction, the CFPB has been an absolute success in meeting its objective. For example, for each dollar of funding in support of the agency, the CFPB has returned about five dollars to victims of financial misconduct. Recent reports have indicated that the Dodd-Frank Act through the CFPB has returned approximately USD 12 million to over 29 million Americans who had fallen victims of financial wrongdoing (Gelzinis et al., 2017).

Arguments for the Dodd-Frank Act

The first argument for the Dodd-Frank Act strongly believes that the Act’s stringent regulations have played an essential role in stabilizing the financial institution. Economists and financial regulators affirm that repealing the law will only result in similar levels of risk-taking that were observed from 2003 to 2007 (Gelzinis et al., 2017). Revoking the Act would loosen the restrictions involving the maintenance of higher capital adequacy ratio amongst financial institutions. In other words, repealing the Dodd-Frank Act will increase the likelihood of more risks among large financial institutions (Karr, 2017). For instance, the financial regulators who have favored the implementation of the Act are mainly concerned about the trade of SWAPS and derivatives OTC (Over the Counter) among banks and investors. They claim that these financial products did not emerge due to the regulation purview prior to the enactment of the Dodd Act. In simple terms, the trading of derivative products such as credit default and default SWAPS obligations were excluded from any regulations (Karr, 2017). Therefore, economists criticize Trump’s Administration move or repealing the Act claiming that amendments to do so could change the structure of the financial sector in which key players of the industry may seek to increase offerings in structured products. Thus the regulation costs could eventually fall.

On the other hand, financial regulators in favor of the Act argue that the Dodd-Frank Act is crucial in monitoring the performance of Wall Street to avoid a future global financial crisis. The Financial Stability Oversight Council id fundamental in identifying risks that affect the performance of the entire financial sector (Valdez & Molyneux, 2010). The FSOC assesses the growth potential of companies and turns over any corporations that are rapidly growing to the Federal Reserve, which further supervises the financial institution. For example, the Dodd-Frank Act obliges the Federal Reserve to force a bank to increase its reserve requirement as a means of regulating its growth. Considerably, this ensures that consumers have adequate funds, thus preventing bankruptcy (Karr, 2017). Similarly, the Dodd-Frank financial reform Act has also established a new Federal Insurance Office that functions to identify insurance firms such as the American International Group Inc., that could potentially create a risk for the entire financial system.

Equally, advocates for the Dodd-Frank Act claim that the Act’s Volcker Rule is crucial in stopping Banks from Gambling with the depositor’s funds (Karr, 2017). The rule prohibits financial institutions from owning or applying hedge funds to maximize their profits. Additionally, the Volcker Rule restricts consumers from using their deposits in trading for the profit of financial institutions. This implies that financial institutions can only employ hedge funds at a customer’s request. However, financial institutions lobby against this restriction, economists have revealed that the Volcker Rule does not impose a hardship to the banks since banks can still trade with three percent of their revenue and that most financial institutions across the economy had reached this minimum by 2015 (Karr, 2017). In other words, this argument considers capital as a buffer in which the Dodd-Frank Act aims at maintaining the financial institutions as “a going concern.” While acting as a buffer capital protects debt holders like small depositors together with their agents as well as the deposit insurance agencies, from the outcomes of financial distress.

Arguments Against the Dodd-Frank Act

On the contrary, critics against the Dodd-Frank Financial Reform Act argue that regulatory burdens that the law imposes significantly make financial institutions in the US less competitive in the global marketplace (Zuluaga, 2018). They believe that the introduction of the regulation augmented the failure of small financial institutions due to the pile of new regulatory restrictions on them. According to Zuluaga (2018), the introduction of the Act resulted in more disadvantages than efforts to curtailing bad practices within the financial sector. Despite eliminating previous regulatory agencies that had affected the performance of the financial system, the Act imposed new restrictions in which it builds a new regime for financial institutions that were considered to be of systematic importance (Zuluaga, 2018). Consequently, the critics claim that the law has also affected mortgage lending rules by its focus on a better reflection of these loans on the banks’ financial statements.

Secondly, the critics against the Act also argue that stringent liquidity regulations tend to raise direct costs since they reduce the ability of financial institutions to offer liquidity services to their customers (Classens, 2014). For instance, these requirements affect a bank’s capacity to provide contingent assurances for credit lines and loans in addition to backstops for companies’ issuance of commercial papers. Moreover, since low-risk levels, short-term debt instruments are significant in providing liquidity benefits to debt holders, liquidity requirements imposed by the Dodd-Frank Act that discourage such funding increases operations costs for financial institutions. Furthermore, an increase in the costs of a bank’s operations, including the hindrance to maturity transformation and risk pooling affects the long-term performance of the financial institutions since they face the challenge to convert the partially illiquid long-term asset into more liquid short-term assets to support its operations (Classens, 2014). Accordingly, the critics are advocating for the repealing of the Dodd-Frank Act since it affects companies’ operations and, in turn, the overall competitive advantage of US financial institutions relative to foreign countries.

Conversely, critics such as Hensarling affirm that the law has created so much regulatory freedom. Hensarling supports this by demonstrating how the financial system involves risky enterprises. The critics are concerned about how the Dodd-Frank Act creates uncertainty in the financial markets and that since the introduction of the regulation, particularly the Volcker Rule, proprietary trading by financial institutions has fallen rapidly. Likewise, financial institutions who are the primary critics against the legislation illustrate how it has limited the ability of banks to lend capital for small start-ups. Despite the law being meant to protect the consumer from risky banking practices set at Wall Street, it as diverged its interest to the extent that it has hindered the access of capital to the consumers. This capital is important to start a business that will create employment opportunities that would fuel the growth of the economy. Accordingly, based on these critics, banks argue for the repeal of the Act since it affects their operations and the overall performance of the economy.

Conclusion

The Dodd-frank Act plays a vital role in making the country’s financial system more stable and ensuring that consumers are protected from toxic financial products than the times before the emergence of the financial crisis. However, despite the firm tenets of the Dodd-Frank Act to stabilize the United States’ financial system, some Republican members in Congress emerged to roll back the Act. While the supporters of the Act believe that the law crucial in stopping Banks from Gambling with the depositor’s funds, critics argue that that the stringent liquidity regulations tend to raise direct costs since they reduce the ability of financial institutions to offer liquidity services to their customers

References

Classens, S. (2014). Capital and liquidity requirements: A review of the issues and literature. Yale J. on Reg., 31, 735.

Gelzinis, G., Zonta, M., Valenti, J., Edelman S. (2017). The Importance of Dodd-Frank, in 6 Charts. Center of American Progress.

Karr R. (2017) Regulator’s Argument in Favor of the Dodd-Frank Act. Market Realist. Retrieved from: https://marketrealist.com/2017/05/repealing-dodd-frank-change-industry/

Madura, J., (2015), Financial Markets and Institutions, Cengage Learning, 11th Edition.

Valdez, S., & Molyneux, P. (2010), An Introduction to Global Financial Markets, Palgrave Macmillan, 6th edition.

Zuluaga, D. (2018). Dodd‐​Frank Is in Trouble – and for Good Reason. CATO Institute. Retrieved from: https://www.cato.org/publications/commentary/dodd-frank-trouble-good-reason